There is a modest recovery underway in the American economy. The Federal Reserve can no longer avoid the looming choice on interest rates and the money supply.
Since the sub-prime crisis began Chairman Bernanke has been the consistent champion of monetary easing. Under his leadership, the Federal Open Market Committee (FOMC) began cutting the Fed Funds target in the fall of 2007, more than two years ago. This was long before the housing collapse had mushroomed into the banking crisis, the financial market panic and worldwide recession. It was well before the severity of the banking, financial and economic problems were recognized by any other central bank. The Fed’s willingness to lead and act was one of the most important factors in forestalling an even more severe recession or depression.
The real Fed funds rate has been effectively zero or slightly negative for more than a year. The Fed’s balance sheet has expanded to $2.2 trillion, including $1.25 trillion of Mortgage Backed Securities (MBS) and $300 billion of US Treasury securities. These experimental programs put a floor under bond prices and in the MBS market often provided the only buyer.
Without Fed purchases of MBS paper and government securities mortgage rates would not have stayed at their historic lows. Banks still hold large amounts of damaged asset backed instruments. Without stable housing prices the value of those securities on bank balance sheets would continue to fall, keeping the institutions perennially in need of capital as the value of their assets declined. The financial crisis was keyed to the stability and perception of the stability of these large institutions. The scale of the Fed intervention in the securitized products market is a direct measure of the essential role of MBS paper in the financial crisis.
The institutional aspect of the financial crisis has run its course. Most of the major recipients of government TARP funds have repaid them. The Fed has said it will end MBS and Treasury support programs on time. But the housing market is not recovered; it is stable. Nationwide housing prices are at the level they were in late 2003, more than 30% below the peak of 2006. But they are still well above the long term trend of increase before the credit and loan expansion in the early part of the decade. The existing MBS values are largely based on those inflated prices. Extremely low mortgage rates courtesy of government tax credits and the Fed have helped stabilize the housing market but they cannot revive it, only employment can.
The other side of the housing rescue coin is inflation and the response of the bond markets. Bond traders cannot view the liquidity pumped into the US economy without seeing inflation. As economic recovery becomes apparent the bond markets have become restive. Interest rates are well below historic norms. There is no other ready conclusion for a recovering and expanding economy with trillions of dollars of created liquidity in its financial system than inflation if these funds not removed.
There is also the unending stream of United States Government debt issuance which will continue to pressure bond prices lower and interest rates higher.
The last piece for the Fed is the dollar. The US currency had regained 5.6% of its November low versus the euro to Friday’s close; the immediate danger has retreated. But the greatest threat to the Fed interest/inflation rate balancing act is still a dollar collapse. A serious fall in the greenback could incite panicky selling in the Treasury market, driving up rates which would quickly stifle the recovery with higher commodity prices, raise mortgage rates, import inflation, and make it much more difficult for the Federal government to fund its deficit.
So the puzzle for the Fed is how to keep the economy from falling into a second tranche of recession while it cleanses the monetary excess from the financial system? How to keep rates high enough to forestall inflation and inflationary expectations in but not so high as to inhibit values in the housing market; high enough to maintain a reasonably strong dollar but not so high as to prevent business borrowing and job creation.
The Fed Funds rate will not be the tool to lead monetary policy out of this liquidity excess. The current 0.25% rate is too useful for maintaining financial institution profitability and it is far too public a rate with unemployment at 10%.
It not the Fed Funds rate that created the monetary overhang but the experimental liquidity programs that the Fed used to combat the financial crisis. And it will be these same types of programs that the Fed will employ in withdrawing the crisis liquidity. The bank term deposit program announced on Tuesday is just the first. No doubt many more will follow. The Fed will keep experimenting until the Governors are satisfied they have it right.